After the Perfect Storm

The Perfect Storm is behind us, common wisdom has
itcertainly, a more benign equity market seems to have
calmed the turmoil. However, the aftereffects promise to be
with us for many years to come.

The Perfect Storm is behind us, common wisdom has
itcertainly, a more benign equity market seems to have
calmed the turmoil. However, the aftereffects promise to be
with us for many years to come.

Analysis of data collected in the 2003 Fidelity
Investments/PLANSPONSOR report on optimizing plan funding
suggests the state of the pension industry has been
affected structurally by the events that came together in
2001 and 2002 to vex the nation's pension fundsand,
regardless of the future direction of the market and of
interest rates, it is unlikely to be "business as usual"
going forward. "Despite the improved performance of the
equity markets in 2003, defined benefit plan sponsors
continue to face significant challenges," says Drew Lawton,
CEO and president of Fidelity Management Trust Company.
"The widespread underfunded status of pension plans has
caused many plan sponsors to question whether or not their
long-term asset allocation and investment strategies
continue to be appropriate. By partnering with PLANSPONSOR,
Fidelity has been able to provide valuable benchmarking
information, and a forum for dialogue, to assist sponsors
and their consultants in addressing this important
question."

The firstperhaps surprisingresult of the
Fidelity/PLANSPONSOR
study is that, as of August 2003, both public and private
pension funds are significantly less well-funded than in
mid-2002. In mid-2002, the study found that 55% of
respondents were overfunded; this year three out of four
plans were underfunded (see table 4). Moreover, 53% of
plans surveyed changed their rate of return assumptions in
the last 12 months, and the average rate of return change
was -72 basis points.

However, it is the structural changes that plan sponsors
are contemplating to their planschanges that seem likely
to be implemented regardless of whether funding ratios once
more dip into the blackthat leap out of the data.
Corporate plans in particular are considering changes in
plan design that were not on the table a year or two ago.
At least half of all plans have considered cash balance or
hybrid plans, changing to a defined contribution plan, and
reducing pension, health, or other benefits (see table 1).
That said, only 12% have considered or implemented a
termination of the defined benefit plan. However, the
willingness to put radical plan design options on the table
(for instance, a third of the respondents said they would
consider total retirement outsourcing if cost benefits
could be demonstratedsee table 9) suggests that the shock
of the rapid about-face from overfunded to underfunded
status has deeply affected the institutional investment
community.

Asset allocation also is undergoing a rethinking but,
there, the change is more incremental. That said, the
status of liabilities and funding is now the most important
driver of asset allocation policy㬣% of respondents identify
it as the single most important driver, compared to return
targets (30%), and investment consultant recommendation
(20%). In terms of specific asset classes, plan sponsors
anticipate decreasing allocations to domestic equity and
fixed income, and increasing allocations to non-US equity,
real estate, and alternatives (see table 3). However,
change is on the marginthe majority of respondents (86%)
believe that the expected risk premium justifies a majority
allocation to equities. On the fixed- income side, the
anecdotal evidence that a more favorable attitude to
longer-duration bonds has emerged is confirmedwhile only
33% of respondents say that they have considered using long
duration bonds as a hedge to liabilities, fully 35% of
those considering this say they are very or somewhat likely
to implement that strategy. Overall, nearly 90% of plans
are considering new strategies to help their funding
situation and more than half have implemented at least
one.

With regard to alternatives, 23% of respondents say they
are increasing their exposure; this is a far cry from the
common wisdom that all and sundry are climbing into
alternatives. Interestingly, 70% of respondents believe
they cannot measure the risk of alternative
investmentsthis is up from 55% in 2002. This translates
into an alarming statistic from a fiduciary
standpointfully 56% of plans with allocations to
alternatives acknowledge that they cannot measure the risk
of these investments.

Finally, an insight into the institutional mindset that
can be interpreted as either an indication of wishful
thinking or the intractability of the funding: Nearly all
funds agree that the most promising solution to the funding
crisis is market recovery. There is no widespread agreement
that any strategy that lies within the powers of
planswhether it be asset- or liability-relatedcan lift
pensions out of the present hole in which they find
themselves.